Chapter 16 Financial Leverage and Capital Structure Policy

Chapter 16 • Financial Leverage and Capital Structure Policy Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Outline • • The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure The Pie Again Observed Capital Structures 17 -1

Capital Restructuring • We are going to look at how changes in capital structure affect the value of the firm, all else equal • Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets • The firm can increase leverage by issuing debt and repurchasing outstanding shares • The firm can decrease leverage by issuing new shares and retiring outstanding debt 17 -2

Choosing a Capital Structure • What is the primary goal of financial managers? • Maximize stockholder’s wealth • We want to choose the capital structure that will maximize stockholder wealth • We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC 17 -3

The Effect of Leverage • How does leverage affect the EPS and ROE of a firm? • When we increase the amount of debt financing, we increase the fixed interest expense. • If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders. • If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders. • Leverage amplifies the variation in both EPS and ROE 17 -4

Example: Financial Leverage, EPS and ROE – Part I • We will ignore the effect of taxes at this stage. • What happens to EPS and ROE when we issue debt and buy back shares of stock? 17 -5

Capital Restructuring Current Capital Structure Proposed Capital Structure Assets $5, 000, 000 Debt $0 $2, 500, 000 Market Value of Equity $5, 000 $2, 500, 000 D/E 0 1 Outstanding Shares 500, 000 250, 000 Share Price $10 Interest N. A. 10% 17 -6

Current Capital Structure: No Debt Recession Expected Expansion EBIT $300, 000 $650, 000 $1, 000 Interest 0 0 0 Net Income $300, 000 $650, 000 $1, 000 ROE 6. 00% 13. 0% 20. 0% EPS $0. 6 $1. 3 $2. 0 17 -7

Proposed Capital Structure: Debt=$2. 5 million Recession Expected Expansion EBIT $300, 000 $650, 000 $1, 000 Interest $250, 000 Net Income $50, 000 $400, 000 $750, 000 ROE 2. 00% 16. 0% 30. 0% EPS $0. 2 $1. 6 $3. 00 17 -8

Financial Leverage: EPS and EBIT 17 -9

Example: Financial Leverage, EPS and ROE – Part II • Variability in ROE • Current: ROE ranges from 6% to 20% • Proposed: ROE ranges from 2% to 30% • Variability in EPS • Current: EPS ranges from $0. 60 to $2. 00 • Proposed: EPS ranges from $0. 20 to $3. 00 • The variability in both ROE and EPS increases when financial leverage is increased. 17 -10

Break-Even EBIT • Find EBIT where EPS is the same under both the current and proposed capital structures. • If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholders. • If we expect EBIT to be less than the break -even point, then leverage is detrimental to our stockholders. 17 -11

Example: Break-Even EBIT 17 -12

Homemade Leverage • Individual investor can have the same leverage effect by borrowing money and buying stock. • The company does not have to change capital structure for a leverage effect. • Suppose that individual investors originally have 100 shares and no debt. Given that a stock price is $10, the market value of equity is equal to $1000. • Homemade leverage: Burrow $1000 and purchase additional 100 shares. Pay $100 as interest expenses. • • 10% interest rate is assumed. TA for individual = $2, 000 =200 shares x $10 per share Equity =$1000, Debt=$1, 000 D/E = 1 17 -13

Example: Homemade Leverage and ROE Recession Expected Expansion No Debt EPS =$ 0. 6 EPS=$1. 3 EPS=$2. 0 D/E =1 EPS= $0. 2 EPS=$1. 6 EPS=$3. 0 No leverage $60 (100 shares) $130 $200 D/E =1 $20 $160 $300 Homemade leverage $120 - $100 $260 -$100 =$20 =$160 $400$100=$300 17 -14

Capital Structure Theory • The value of the firm is determined by the cash flows to the firm and the risk of the assets. • Changing firm value • Change the risk of the cash flows. • Change cash flows. • Modigliani and Miller Theory of Capital Structure • Proposition I – Firm value is independent of the firm’s capital structure. • Proposition II – WACC does not change and cost of equity increase with D/E. 17 -15

Basic Assumption • We only focus on OCF. • It is reasonable to assume that capital spending and working capital are not influenced by change in capital structure. • No depreciation because depreciation does not influence the firm’s value when D/E changes. • Leveraged OCF= (EBIT – Interests) (1 -t) + Interests + Depreciation • Unleveraged OCF= (EBIT- 0) (1 -t)+ Deprecation • Leveraged OCF – Unleveraged OCF = t * Interests 17 -16

Capital Structure Theory Under Three Special Cases • Case I – Assumptions • No corporate or personal taxes • No bankruptcy costs • Case II – Assumptions • Corporate taxes, but no personal taxes • No bankruptcy costs • Case III – Assumptions • Corporate taxes, but no personal taxes • Bankruptcy costs 17 -17

Case I – Propositions I and II • MM Proposition I • The value of the firm is NOT affected by changes in the capital structure. • The cash flows of the firm do not change; therefore, value doesn’t change. • MM Proposition II • The WACC of the firm is NOT affected by capital structure. • Cost of equity is increased by increasing D/E. 17 -18

Case I - Equations • WACC = RA = (E/V)RE + (D/V)RD • RE = RA + (RA – RD)(D/E) • RA is the “cost” of the firm’s business risk, i. e. , the risk of the firm’s assets. • The risk of assets is independent of capital structure. • (RA – RD)(D/E) is the “cost” of the firm’s financial risk, i. e. , the additional return required by stockholders to compensate for the risk of leverage. • When D=0, RE is called as Ru where unleveraged firm’s cost of capital. 17 -19

Figure 16. 3 17 -20

Case I - Example • Information: Required return on assets = 16%, cost of debt = 10%; percent of debt to firm’s value = 45% • What is the cost of equity? • RE = 16 + (16 - 10)(. 45/. 55) = 20. 91% • Suppose instead that the percent of debt =60%. What is the cost of equity? • RE = 16 + (16 - 10)(. 6/. 4) = 16+9 =25 • Based on this information, how can you describe the relation between the cost of equity and the debt –equity ratio? • As the debt-equity ratio increases, the cost of equity increases. 17 -21

The CAPM, the SML and Proposition II • How does financial leverage affect the systematic risk? • CAPM: E(RA )= Rf + A(E(RM)– Rf) • Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets. • WACC = RA = (E/V)RE + (D/V)RD • Replace returns of equity and debt with the CAPM • A= (E/V) E + (D/V) D 17 -22

Business Risk and Financial Risk • E = A+ ( A - D)D/E • Therefore, the systematic risk of the stock depends on: • Systematic risk of the assets, A, (Business risk) • Level of leverage, D/E, (Financial risk) • In case 1 (no taxes and no bankruptcy costs) • MM proposition I and II hold. • Cost of equity increases by D/E. • Systematic risk of equity increases by D/E. 17 -23

Case II – Cash Flow • Interest is tax deductible. • Therefore, when a firm adds debt, it reduces taxes, all else equal. • The reduction in taxes increases the cash flow of the firm. • How should an increase in cash flows affect the value of the firm? • Assume that the market value of Debt is $6, 250 and annual interest rate is 8%. 17 -24

Case II - Example Unlevered Firm EBIT Levered Firm 5000 0 500 Taxable Income Taxes (34%) 5000 4500 1700 1530 Net Income 3300 2970 OCF 3300 3470 Interest u We do not consider depreciation because it does not affect the result. 17 -25

Interest Tax Shield • Annual interest tax shield • Tax rate times interest payment • $6, 250 in 8% debt = $500 in interest expense • Assume that coupon rate is equal to YTM. • Annual tax shield =. 34(500) = 170 • Present value of annual interest tax shield • Assume perpetual debt for simplicity • PV = 170 /. 08 = 2125 • PV = D(RD)(TC) / RD = D TC = 6250(. 34) = 2125 17 -26

Case II – Proposition I • The value of the firm increases by the present value of the annual interest tax shield • Value of a levered firm = value of an unlevered firm + PV of interest tax shield • Assuming perpetual cash flows (EBIT (1 T)) • VU = EBIT(1 -T) / RU, RU is the cost of capital for the unleveraged firm. • VL = VU + DTC , DTC = D(RD)(TC) / RD =D Tc 17 -27

Example: Case II – Proposition I • Example • EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% • EBIT and Debt are assumed to be perpetual. • VU = 25(1 -. 35) /. 12 = $135. 42 million • VL = 135. 42 + 75(. 35) = $161. 67 million • E = 161. 67 – 75 = $86. 67 million • Firm value increases by D/E, violating MM proposition I. 17 -28

Figure 16. 4 17 -29

Case II – Proposition II • The WACC decreases as D/E increases because of the government subsidy on interest payments • RA = (E/V)RE + (D/V)(RD)(1 -TC) --(1) • RA =RU [1 -TC (D/V)] = RU [E+(1 -TC)D]/V, ---(2) • RU is the cost of capital for unleveraged firm (all equity financed firm) • RA is the cost of capital (WACC) for leveraged firm. • [ Equation (2) comes from (VL = VU + DTC )]. • RE = RU + (RU – RD)(D/E)(1 -TC), by using (1) and (2). • Example (RU = 12, RD= 9), what is the leveraged firm’s cost of equity and WACC? • RE = 12 + (12 -9)(75/86. 67)(1 -. 35) = 13. 69% • RA = (86. 67/161. 67)(13. 69) + (75/161. 67)(9)(1 -. 35) RA = 10. 05% 17 -30

Example: Case II – Proposition II • Example • • • EBIT = 25 million; Tax rate = 35%; Cost of debt = 9%; Unlevered cost of capital = 12% • EBIT and Debt are assumed to be perpetual. • VL = 135. 42 + 75(. 35) = $161. 67 million, if D=75 Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1. D/E =1 VL = Vu + D t = $135. 42 + D (0. 35) = E + D = 2 D D = 82. 07 = E VL = 82. 07 (2) = 164. 14 • Since D/E increases, the firm’s value increases. 17 -31

WACC and the firm’s value • What will happen to the cost of equity under the new capital structure? (RU = 12, RD= 9) • RE = 12 + (12 - 9)(1)(1 -. 35) = 13. 95% • What will happen to the weighted average cost of capital? • RA =. 5(13. 95) +. 5(9)(1 -. 35) = 9. 9% • VL = EBIT (1 -t) / RA = 25 (1 -0. 35)/0. 099 = 164. 14 • VL = EBIT (1 -t)/Ru + D t = Vu + D t = EBIT (1 -t)/RA • When WACC is used, OCF should not consider tax shields of interests because the discount rate of WACC already considers tax shield. 17 -32

Figure 16. 5 17 -33

Case III • Now we add bankruptcy costs • As the D/E ratio increases, the probability of bankruptcy increases. • This increased probability will increase the expected bankruptcy costs. • At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost. • At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added. 17 -34

Bankruptcy Costs • Financial distress • Significant problems in meeting debt obligations. • Most firms that experience financial distress do not ultimately file for bankruptcy. • Direct costs • Legal and administrative costs • Ultimately cause bondholders to incur additional losses • Disincentive to debt financing 17 -35

More Bankruptcy Costs • Indirect bankruptcy costs • Larger than direct costs, but more difficult to measure and estimate • Stockholders want to avoid a formal bankruptcy filing. • Bondholders want to keep existing assets intact so they can at least receive that money. • Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business. • The firm may also lose sales, experience interrupted operations and lose valuable employees. 17 -36

Figure 16. 6 17 -37

Figure 16. 7 17 -38

Figure 16. 8 17 -39

Conclusions • Case I – no taxes or bankruptcy costs • No optimal capital structure • Case II – corporate taxes but no bankruptcy costs • Optimal capital structure is almost 100% debt. • Each additional dollar of debt increases the cash flow of the firm. • Case III – corporate taxes and bankruptcy costs • Optimal capital structure is a certain combination of debt and equity. • Occur where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs. 17 -40

Figure 16. 9 17 -41

The Total Value of the Firm • Total value of the firm = marketed claims + nonmarketed claims • Marketed claims are the claims of stockholders and bondholders. • Non-marketed claims are the claims of the government and other potential stakeholders. • The overall value of the firm is unaffected by changes in capital structure. • The division of value between marketed claims and non-marketed claims may be impacted by capital structure decisions. 17 -42

Observed Capital Structure • Capital structure does differ by industries. • Differences according to Cost of Capital 2000 Yearbook by Ibbotson Associates, Inc. • Lowest levels of debt • Drugs with 2. 75% debt • Computers with 6. 91% debt • Highest levels of debt • Steel with 55. 84% debt. • Department stores with 50. 53% debt. 17 -43

Announcement of Debt Issues • Stock price normally increases when a company announces unexpected debt issue. • Good news to the company who will issue debt. • This is not because of expected tax benefits but because of asymmetric information between the company and investors. • Why? • Signaling Hypothesis • The market interprets debt issue announcement as good news because investors expect that the company will have enough earnings in the future to cover the debt burden. -> The company has confidence about future earnings. • Misvaluation hypothesis • The company knows about valuation of its stock. When it believes that its stock is undervalued. It prefers debt to equity. 17 -44

Announcement of Equity Issues • It is exactly opposite to debt issues. • Stock price normally decreases when the company unexpectedly announces equity issues. • Why? • Signaling Hypothesis • The market interprets equity issue announcement as bad news because investors expect that the company will have enough earnings in the future to cover the debt burden. -> The company has confidence about future earnings. • Misvaluation hypothesis • The company knows about valuation of its stock. When it believes that its stock is overvalued. It prefers debt to equity 17 -45

Pecking Order Theory • Pecking order theory • Use internal financing first • Issue debt next • new equity last • Pecking order theory is based on asymmetric information about valuation of stock. • Since the effect of equity announcement on stock price is negative, the company does not like issue equity. • The pecking-order theory is in contrast to the optimal capital structure theory • there is no target D/E ratio • profitable firms will use less debt 17 -46

Quick Quiz • Explain the effect of leverage on EPS and ROE • How do we determine the optimal capital structure? • What is the optimal capital structure in the three cases that were discussed in this chapter? • What is the pecking order theory? • Effect of debt or equity announcement on stock price 17 -47

Chapter 16 • End of Chapter Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved.